Microeconomics An Intuitive Approach With Calculus 2nd Edition Thomas Nechyba Test Bank

Microeconomics An Intuitive Approach with Calculus 2nd Edition Thomas Nechyba Test Bank
Microeconomics An Intuitive Approach with Calculus

2nd Edition Thomas Nechyba Test Bank
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True / False
1. If leisure is an inferior good, then an increase in wages will cause workers to work more.
a. True
b. False
ANSWER: True
RATIONALE: In this case, both the substitution and wealth effect cause the worker to reduce leisure consumption
as wages increase.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM
2. In a model with leisure hours and a composite consumption good, you cannot tell whether workers will work more or
less if tastes are quasilinear in the consumption good.
a. True
b. False
ANSWER: True
RATIONALE: The substitution effect will cause workers to work less -- but leisure is a normal good (since tastes
are quasilinear in consumption), and this implies a wealth effect in the other direction.
POINTS: 1
3. For decreases in wage taxes, substitution effects put negative pressure on tax revenues while wealth effects put positive
pressure on tax revenues.
a. True
b. False
ANSWER: False
RATIONALE: Decreases in wage taxes cause increases in after-tax wages -- and increases in wages cause
substitution effects that cause increases in work hours. If people work more, then this causes upward
pressure on tax revenue, not negative pressure. At the same time, the wealth effect from higher
wages suggests people will work less (assuming leisure is a normal good) -- pushing in the opposite
direction.
POINTS: 1
4. The more substitutable current consumption is with future consumption, the more likely it is that an increase in the
interest rate will cause an increase in savings.
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a. True
b. False
ANSWER: True
RATIONALE: The substitution effect causes a decrease in current consumption when the interest rate increases,
while the wealth effect causes the opposite (assuming current consumption is a normal good).
POINTS: 1
5. Assuming no kinks in indifference curves and assuming our usual assumptions about tastes hold, someone who
currently neither saves nor borrows will begin to borrow when the interest rate falls.
a. True
b. False
ANSWER: True
RATIONALE: The new (dashed) budget will pass through the original optimum A -- with the new optimum involving
more consumption and thus borrowing.
POINTS: 1
6. As long as both current and future consumption are normal goods, a decrease in the interest rate will result in a drop in
savings.
a. True
b. False

ANSWER: False
RATIONALE: A decrease in the interest rate will cause a substitution effect that points in the direction of less
savings but a wealth effect that points in a direction of more savings. Which dominates depends on
the size of the substitution effect relative to the wealth effect.
POINTS: 1
7. When tastes over current and future consumption take the Cobb-Douglas form, interest rates have no impact on savings
when income is earned in the current period but not in the future.
a. True
b. False
ANSWER: True
RATIONALE: For Cobb-Douglas tastes, the substitution and wealth effects are exactly offsetting.
POINTS: 1
DIFFICULTY: B-Section Material
8. When tastes over current and future consumption are characterized by Cobb-Douglas utility functions, a borrower who
has no income now and all income in the future will borrow more when the interest rate falls.
a. True
b. False
ANSWER: True
RATIONALE: When the interest rate falls, the substitution effect tells us to borrow less while the wealth effect tells
us to borrow more. For Cobb-Douglas tastes, these effects are exactly offsetting on the “future
consumption” axis -- which implies that current consumption increases (because more can be
borrowed under the lower interest rate while keeping future consumption constant.)
POINTS: 1
9. When the elasticity of substitution in the constant elasticity of substitution utility function lies above 1, an increase in
the interest rate will cause a saver to save less.
a. True
b. False
ANSWER: False
RATIONALE: Cobb-Douglas tastes --- which are CES tastes with elasticity of substitution of 1, represent the
borderline case where an increase in the interest rate causes no change in savings behavior. For
higher elasticities of substitution, the substitution effect dominates --- causing savings to increase

with the interest rate.
POINTS: 1
10. In a model of consumption and leisure, a drop in the wage will cause workers to work more if tastes are quasilinear in
consumption.
a. True
b. False
ANSWER: False
RATIONALE: If tastes are quasilinear in consumption, then leisure is a normal good --- and how workers respond
to changing wages will therefore depend on the relative size of substitution and wealth effects on the
leisure axis.
POINTS: 1
11. In a model of consumption and leisure, a drop in the wage will cause workers to work less if tastes are quasilinear in
leisure.
a. True
b. False
ANSWER: True
RATIONALE: The substitution effect points in the direction of more leisure (i.e. less work), and the wealth effect is
zero on the leisure axis.
POINTS: 1

12. Taxing savings in ways that lower the interest rate received by savers will lower savings.
a. True
b. False
ANSWER: False
RATIONALE: It depends on whether wealth effects outweigh substitution effects.
POINTS: 1
13. A friend is currently earning income but does not expect to earn income in the future. When the interest rate rose, I
observed him saving less. From this, I can conclude that current consumption is an inferior good for my friend.
a. True
b. False
ANSWER: False
RATIONALE: In this graph, both current and future consumption are normal goods -- and current consumption now
increases, implying savings decrease.
POINTS: 1

14. If you earn income now and expect to live off savings in the future, then a raise now will cause you to save more so
long as consumption -- now and in the future -- is a normal good.
a. True
b. False
ANSWER: True
RATIONALE: This is a pure wealth effect with no substitution effect. Thus, consumption now and in the future will
increase, implying that you will save more (which is the only way future consumption can increase in
the absence of a change in the interest rate.)
POINTS: 1
15. The amount of work a person will do as wage increases depends entirely on the size of the wealth effect.
a. True
b. False
ANSWER: False
RATIONALE: Whether a person will work more or less as wage increases depends not only on the size of the
wealth effect, but also its effect relative to the substitution effect.
POINTS: 1
DIFFICULTY: A section material
DATE CREATED: 10/8/2015 10:15 AM
DATE MODIFIED: 10/8/2015 10:37 AM
16. Because workers tend to work more when their after-tax wage increases, the government can increase tax revenue by
cutting taxes.
a. True
b. False
ANSWER: False
RATIONALE: The combination of substitution and wealth effects leading workers to work more when their after-
tax wage increases is NOT sufficient for the government to increase tax revenue by cutting taxes.
This is because substitution effects in the labor market suggest that workers will work less as wage
taxes increase, so they will pay less in additional tax revenues, and tax revenue will decrease, not
increase.
POINTS: 1
DIFFICULTY: A section material
DATE CREATED: 10/8/2015 10:15 AM

Subjective Short Answer
17. Suppose you know I am only about consumption this year and consumption next year. Suppose also that I have an
income this year but do not expect to have an income next year. Explain your answers.
a. You notice that I save more after the interest rate falls. Can you tell whether “consumption now” is a normal, inferior or
Giffen good?
b. Suppose I also received an unexpected raise at work and you overhear me say: “Cool, I am even Steven. Now that I
have my raise, I am just as happy as I was before the interest rate fell and I did not yet have a raise.” Without knowing
anything more, can you tell whether I consume more or less next year than I would have consumed had neither of the two
changes happened?
ANSWER: a. Yes, you can tell. A drop in the interest rate gives rise to a substitution effect that says consume
more now. If consumption now actually falls, it means that the wealth effect pushed in the opposite
direction (for a decrease in wealth from the compensated to the final budget) -- so consumption now
is a normal good.
b. Here, we are staying on the same indifference curve -- but the slope of the budget has become
shallower. This implies a move to the right along the indifference curve -- a move to more
consumption now and less consumption next year. (This is, of course, just a pure substitution effect.)
POINTS: 1
QUESTION TYPE: Subjective Short Answer
18. Suppose you own a stock portfolio composed of shares in firms that are part of the financial services industry. You
don’t work – all you do is plan your consumption now and when you retire, and the only asset you have is your stock
portfolio. In this problem, model your decisions in a graph with “consumption now” on the horizontal axis and
“consumption at retirement” on the vertical. Throughout, assume that the long run rate of return of investment is r over
the period from now to retirement.
a. Graph your initial budget constraint – and indicate where in your graph your endowment point lies as well as what the
slope of the budget constraint is.
b. This morning, you woke up to find that the current financial crisis has wiped out some of the firms in your stock
portfolio. As a result, your portfolio is only worth half of what it was yesterday. Assuming that the long run rate of return
r remains unchanged, what has just happened to your budget constraint?
c. Assuming that consumption now and in the future is always a normal good, will you cut down on your consumption
plans now?
d. Now suppose I offer you a deal: I will give you enough cash to raise your current (financial) wealth back to what it was
yesterday, but in exchange you agree to give me half of any return in your investments when you retire. You carefully
analyze the deal and calculate that, under this deal, you could in fact just afford to consume the same bundle (but not
strictly more) as you would without the deal. Will you accept the deal?
e. Does your answer to (d) depend on our assumption that consumption is always a normal good?
f. Can you tell whether, if you accept the deal, you will consume more than you otherwise would have? What does your
answer depend on?
g. Can you tell whether, if you accept the deal, you consume more now than you had planned yesterday before the
financial crisis wiped out half your wealth? What does your answer depend on?
ANSWER: a. b.

c. This is a pure “income” change -- which means consumption now will fall (give that consumption
is a normal good).
d. Yes, you will accept the deal since it makes bundles that lie above your current indifference curve
available.
e. No -- it does not depend on whether or not consumption is normal.
f. You will definitely consume more now (at B) -- and this only depends on consumption across time
being at least somewhat substitutable.
g. You might consume more or less now depending on how large the substitution effect is. We know
in the graph how C and A are related (given the homotheticity of tastes). But B -- the point under the
deal -- could lie to either side of C.

POINTS: 1
19. In the U.S., everyone has to pay social security taxes on labor income until pre-tax income reaches a certain amount
after which no additional taxes are due. Consider the case of workers A, B and C who have 60 hours of leisure per week
and who earn an hourly wage of $40. Suppose the social security tax is 50% up to a pre-tax weekly income of $1,200 and
then falls to zero for any income above $1,200 per week. Assume tastes are homothetic.
a. Worker A is observed to work 40 hours per week under this tax system. Is he working more or less than he would if the
system were abolished?
b. Worker B is observed to work 30 hours a week under this tax system. Is he working more or less than he would if the
c.Worker C is observed to work 20 hours per week under this system. Is he working more or less than he would if the
d. Could any of the three workers above share exactly the same tastes?
e. For which of these workers is there no deadweight loss from the tax?
ANSWER:
a. Worker A is working more -- he chooses A’ without the tax and A with tax.

Microeconomics An Intuitive Approach with Calculus 2nd Edition Thomas Nechyba Test Bank
b. Worker B is working more -- he chooses B’ without the tax and B with the tax.
c. We cannot tell whether worker C is working more or less -- it depends on the size of the
substitution effect.
d. Yes -- worker’s A and C.
e. There is no deadweight loss for workers A and B because neither experiences a substitution effect.
The only way there would be no deadweight loss for worker C is if worker C’s tastes were perfectly
complementary in leisure and consumption.
POINTS: 1
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Microeconomics An Intuitive Approach with Calculus 2nd Edition Thomas Nechyba Test Bank

Microeconomics An Intuitive Approach with Calculus

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zero on the leisure axis.

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e. No -- it does not depend on whether or not consumption is normal.

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d. Yes -- worker’s A and C.

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